The state of modern macroeconomics is not good; John Cochrane, professor of finance at the University of Chicago, senior fellow of the Hoover Institution, and adjunct scholar of the Cato Institute, writing in Thursday’s Wall Street Journal, thinks macroeconomics is a failure. Perhaps so, but he has trouble explaining why.

The problem that Cochrane is chiefly focused on is slow growth.

Output per capita fell almost 10 percentage points below trend in the 2008 recession. It has since grown at less than 1.5%, and lost more ground relative to trend. Cumulative losses are many trillions of dollars, and growing. And the latest GDP report disappoints again, declining in the first quarter.

Sclerotic growth trumps every other economic problem. Without strong growth, our children and grandchildren will not see the great rise in health and living standards that we enjoy relative to our parents and grandparents. Without growth, our government’s already questionable ability to pay for health care, retirement and its debt evaporate. Without growth, the lot of the unfortunate will not improve. Without growth, U.S. military strength and our influence abroad must fade.

Macroeconomists offer two possible explanations for slow growth: a) too little demand — correctable through monetary or fiscal stimulus — and b) structural rigidities and impediments to growth, for which stimulus is no remedy. Cochrane is not a fan of the demand explanation.

The “demand” side initially cited New Keynesian macroeconomic models. In this view, the economy requires a sharply negative real (after inflation) rate of interest. But inflation is only 2%, and the Federal Reserve cannot lower interest rates below zero. Thus the current negative 2% real rate is too high, inducing people to save too much and spend too little.

New Keynesian models have also produced attractively magical policy predictions. Government spending, even if financed by taxes, and even if completely wasted, raises GDP. Larry Summers and Berkeley’s Brad DeLong write of a multiplier so large that spending generates enough taxes to pay for itself. Paul Krugman writes that even the “broken windows fallacy ceases to be a fallacy,” because replacing windows “can stimulate spending and raise employment.”

If you look hard at New-Keynesian models, however, this diagnosis and these policy predictions are fragile. There are many ways to generate the models’ predictions for GDP, employment and inflation from their underlying assumptions about how people behave. Some predict outsize multipliers and revive the broken-window fallacy. Others generate normal policy predictions—small multipliers and costly broken windows. None produces our steady low-inflation slump as a “demand” failure.

Cochrane’s characterization of what’s wrong with New Keynesian models is remarkably superficial. Slow growth, according to the New Keynesian model, is caused by the real interest rate being insufficiently negative, with the nominal rate at zero and inflation at (less than) 2%. So what is the problem? True, the nominal rate can’t go below zero, but where is it written that the upper bound on inflation is (or must be) 2%? Cochrane doesn’t say. Not only doesn’t he say, he doesn’t even seem interested. It might be that something really terrible would happen if the rate of inflation rose about 2%, but if so, Cochrane or somebody needs to explain why terrible calamities did not befall us during all those comparatively glorious bygone years when the rate of inflation consistently exceeded 2% while real economic growth was at least a percentage point higher than it is now. Perhaps, like Fischer Black, Cochrane believes that the rate of inflation has nothing to do with monetary or fiscal policy. But that is certainly not the standard interpretation of the New Keynesian model that he is using as the archetype for modern demand-management macroeconomic theories. And if Cochrane does believe that the rate of inflation is not determined by either monetary policy or fiscal policy, he ought to come out and say so.

Cochrane thinks that persistent low inflation and low growth together pose a problem for New Keynesian theories. Indeed it does, but it doesn’t seem that a radical revision of New Keynesian theory would be required to cope with that state of affairs. Cochrane thinks otherwise.

These problems [i.e., a steady low-inflation slump, aka “secular stagnation”] are recognized, and now academics such as Brown University’s Gauti Eggertsson and Neil Mehrotra are busy tweaking the models to address them. Good. But models that someone might get to work in the future are not ready to drive trillions of dollars of public expenditure.

In other words, unless the economic model has already been worked out before a particular economic problem arises, no economic policy conclusions may be deduced from that economic model. May I call this Cochrane’s rule?

Cochrane the proceeds to accuse those who look to traditional Keynesian ideas of rejecting science.

The reaction in policy circles to these problems is instead a full-on retreat, not just from the admirable rigor of New Keynesian modeling, but from the attempt to make economics scientific at all.

Messrs. DeLong and Summers and Johns Hopkins’s Laurence Ball capture this feeling well, writing in a recent paper that “the appropriate new thinking is largely old thinking: traditional Keynesian ideas of the 1930s to 1960s.” That is, from before the 1960s when Keynesian thinking was quantified, fed into computers and checked against data; and before the 1970s, when that check failed, and other economists built new and more coherent models. Paul Krugman likewise rails against “generations of economists” who are “viewing the world through a haze of equations.”

Well, maybe they’re right. Social sciences can go off the rails for 50 years. I think Keynesian economics did just that. But if economics is as ephemeral as philosophy or literature, then it cannot don the mantle of scientific expertise to demand trillions of public expenditure.

This is political rhetoric wrapped in a cloak of scientific objectivity. We don’t have the luxury of knowing in advance what the consequences of our actions will be. The United States has spent trillions of dollars on all kinds of stuff over the past dozen years or so. A lot of it has not worked out well at all. So it is altogether fitting and proper for us to be skeptical about whether we will get our money’s worth for whatever the government proposes to spend on our behalf. But Cochrane’s implicit demand that money only be spent if there is some sort of scientific certainty that the money will be well spent can never be met. However, as Larry Summers has pointed out, there are certainly many worthwhile infrastructure projects that could be undertaken, so the risk of committing the “broken windows fallacy” is small. With the government able to borrow at negative real interest rates, the present value of funding such projects is almost certainly positive. So one wonders what is the scientific basis for not funding those projects?

Cochrane compares macroeconomics to climate science:

The climate policy establishment also wants to spend trillions of dollars, and cites scientific literature, imperfect and contentious as that literature may be. Imagine how much less persuasive they would be if they instead denied published climate science since 1975 and bemoaned climate models’ “haze of equations”; if they told us to go back to the complex writings of a weather guru from the 1930s Dustbowl, as they interpret his writings. That’s the current argument for fiscal stimulus.

Cochrane writes as if there were some important scientific breakthrough made by modern macroeconomics — “the new and more coherent models,” either the New Keynesian version of New Classical macroeconomics or Real Business Cycle Theory — that rendered traditional Keynesian economics obsolete or outdated. I have never been a devote of Keynesian economics, but the fact is that modern macroeconomics has achieved its ascendancy in academic circles almost entirely by way of a misguided methodological preference for axiomatized intertemporal optimization models for which a unique equilibrium solution can be found by imposing the empirically risible assumption of rational expectations. These models, whether in their New Keynesian or Real Business Cycle versions, do not generate better empirical predictions than the old fashioned Keynesian models, and, as Noah Smith has usefully pointed out, these models have been consistently rejected by private forecasters in favor of the traditional Keynesian models. It is only the dominant clique of ivory-tower intellectuals that cultivate and nurture these models. The notion that such models are entitled to any special authority or scientific status is based on nothing but the exaggerated self-esteem that is characteristic of almost every intellectual clique, particularly dominant ones.

Having rejected inadequate demand as a cause of slow growth, Cochrane, relying on no model and no evidence, makes a pitch for uncertainty as the source of slow growth.

Where, instead, are the problems? John Taylor, Stanford’s Nick Bloom and Chicago Booth’s Steve Davis see the uncertainty induced by seat-of-the-pants policy at fault. Who wants to hire, lend or invest when the next stroke of the presidential pen or Justice Department witch hunt can undo all the hard work? Ed Prescott emphasizes large distorting taxes and intrusive regulations. The University of Chicago’s Casey Mulligan deconstructs the unintended disincentives of social programs. And so forth. These problems did not cause the recession. But they are worse now, and they can impede recovery and retard growth.

Where, one wonders, is the science on which this sort of seat-of-the-pants speculation is based? Is there any evidence, for example, that the tax burden on businesses or individuals is greater now than it was let us say in 1983-85 when, under President Reagan, the economy, despite annual tax increases partially reversing the 1981 cuts enacted in Reagan’s first year, began recovering rapidly from the 1981-82 recession?

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35 Responses to “John Cochrane on the Failure of Macroeconomics”

I find myself agreeing with both you and Cohrane. It *is* true that modern macroeconomic models are not in a place where one can claim they are a scientific basis for recommending policy (though this applies just as much to ‘freshwater’ macro as to saltwater). On the other hand, there are reasons for stimulus that do not rest on these models, such as low borrowing costs and much needed boosts to infrastructure. Cochrane is right about the former, but is kidding himself if he thinks that is the only or main reason economists are recommending stimulus.

2. If alive, Keynes would have told us that deficits in the US would not produce jobs in the U.S. but would only produce net jobs in China. Here is a good short explanation http://bit.ly/159b1RW

3. Macroeconomics fails as science because it fails to incorporate what matters when it comes to growth. It has long been shown that the new ideas and know that produce growth—-Prof Brad Delong had a good post not long ago on knowhow—develop most always in a city with a ‘agglomeration economics” http://bit.ly/1jAtoaU It takes little walking around most American cities to realize they aren’t working and haven’t worked well in this way for some time. If you want growth in the US, our policies should be aimed at making our cities healthy such that the benefits of agglomeration economics return

“In other words, unless the economic model has already been worked out before a particular economic problem arises, no economic policy conclusions may be deduced from that economic model. May I call this Cochrane’s rule”?

Yes you should. If you want to test a policy, without knowing with a certain degree of certitude the effects in advance (as you don’t have the right model), you might do that. Any possible failure, though, rests on the shoulder of a poor science, as the one you advocate.

Reblogged this on Explorations in Political Economy and commented:
Indeed! ” … modern macroeconomics has achieved its ascendancy in academic circles almost entirely by way of a misguided methodological preference for axiomatized intertemporal optimization models for which a unique equilibrium solution can be found by imposing the empirically risible assumption of rational expectations. These models, whether in their New Keynesian or Real Business Cycle versions, do not generate better empirical predictions than the old fashioned Keynesian models, and, as Noah Smith has usefully pointed out, these models have been consistently rejected by private forecasters in favor of the traditional Keynesian models. It is only the dominant clique of ivory-tower intellectuals that cultivate and nurture these models. The notion that such models are entitled to any special authority or scientific status is based on nothing but the exaggerated self-esteem that is characteristic of almost every intellectual clique, particularly dominant ones.”

Until now I have not read John Cochrane regularly. But I intend to start doing so, because there are precious few people these days writing in publications such as the WSJ, that more growth is needed. Too many people on the left and the right, are convinced that more growth is not needed. Perhaps macroeconomics is not a “failure”, but it darn sure needs to become more of an applied discipline for real growth solutions than it presently is.

Cochrane has published mostly empirical papers in his life…on the other hand Paul Krugman spent most of his career without publishing one…so I dont think you are right about how Cochrane forms his views…

anyway, the papers you cite are about what caused the recession, not about why it continues to be slow (and is expected to be that way)…so interesting, but ultimately irrelevant

When (does Cochrane say) did US business leaders and entrepreneurs became a band of weenie-wimps?

I am all for the least regulation and taxes possible. Maybe even a right-winger by some standards. I am certainly pro-business.

But taxes were much higher and regulations arguably more onerous in the 1960s—and real per capita incomes boomed by one-third in the decade. Inflation was not as high as remembered, but did top out at 6 percent in 1969 (as measured by CPI, it was lower on PCE).

An talk about structural impediments? Big Labor, Big Steel, Big Auto, little foreign trade, rate-controlled transportation, rate-controlled savings, and a top MTR above 90 percent! Moreover, we had a huge military complex, consuming 10 percent of GDP (Russia was Russia in those days).

The the economy boomed! Thanks to a pro-growth monetary policy.

Then we had a good run from 1982 to 2007, with inflation ranging around various single digits, often more than 2 percent.

Today’s business people have not had to face a Cuban Missile Crisis, a Vietnam War, race riots in the streets, or ever rising urban crime rates. I will concede the Iraqistan follies have been a gigantic waste of money and taxpayer burden. But basically, life has been easy, and government good in the USA. Business people are not quaking in the boots.

Even more strangely, Cochrane recently authored a paper for the Hoover Institution, in which he advocated more QE until the entire national debt is in bank reserves.

I wonder if this Cochrane WSJ soap-boxer is just a way to get his right-wing “fred” back. I do not think his Hoover mission went well.

I did a 4-compartment model of the domestic macro problem as a short cartoon at the following address. Problem is, my model isn’t mathematizable, it is common-sensical — but economists require math models in the same manner that medieval scholastic required angels on a pinhead. Nevertheless, here is what happened, straight up:

Unlearningecon, Sorry, but I had troubling figuring out what the antecedents of your pronouns in the last sentence.

John, I wasn’t trying to be nice or “not nice.” If US deficits would produce no jobs in the US only in China, why did the recession in the US affect jobs in the US not in China? Agglomeration economies are very interesting, and deserve encouragement, but it’s not clear to me why it is cyclically significant.

Tim, Sorry, just can’t figure out the antecedent of “the one” in the last sentence of your comment.

Mayo, Many thanks.

TH, Thanks for the link. As I suggested in my post, axiomitization may be fine for geometry, but it is not conducive to the progress of empirical science. Karl Popper made that point at least a half century ago. Too bad economists have not been paying attention.

Alek, Noah Smith points out that in principle it would be preferable to have a single explanation for the recession and the slow recovery (especially since fast recoveries tend to follow deep downturns). Positing two different causes is ok, but the burden of proof is on the one claiming that there is a second cause different from the first.

Benjamin, One would think that people would be aware of that history, but since it’s inconvenient, they just forget about it. I made the point a year or two ago when I criticized John Taylor for making this sort of odd historical claim. He tried to explain his way out of it, but not very convincingly.

Tom, Noah is more sympathetic to New Classical type models than I am, but I generally agreed with what he wrote.

Lee, Nice job. Economists don’t really require math models, but they have been brainwashed into thinking they do.

Lee, I thought I was going to hate your video, but it’s actually kind of interesting (and short, which was nice). It’s like a written argument with animations to illustrate the abstract ideas. And it wasn’t crazy sounding, though I doubt many people will be convinced to change their mind by it. Also, I’m skeptical that such a story really isn’t “mathematizable.”

David, on the subject of “Macro debates” (as John puts it) in Noah Smith’s final paragraph of his critique of Cochrane’s post, he wrote this:

“If you have two completely separate explanations – one for the recession and one for the slow recovery – you’re adding a lot of free parameters to your model. In general, model complexity should be penalized, as with some sort of information criterion.”

I’ll return to why I mention this quote in a minute. Now if you were evaluating a completely new macro theory with just two core hypothesis, both of which involved price, and which produced these results from a three-parameter model based on that theory, comparing its theoretical inflation rate against empirical data w/o the benefit of any “smoothing,” while a competing 42-parameter Fed DSGE model with the benefit of “smoothing” produced these results, would that pique your interest? (Note: the Fed model is the SWFF and the Fed results are expressed in terms of a GDP deflator, which accounts for the different scales on the y-axis between the two plots)

Now back to Noah’s quote: by coincidence, the author of the above model (he calls it “ITM”) today used one of those “information criterion” (the AIC) that Noah linked to to do a quick analysis, and this was his conclusion:

“I just realized the NY Fed model has 42 parameters compared to the ITM model that has 3. By the AIC (which incidentally, Noah Smith just referred to a few minuted ago), that means the likelihood function for the Fed model would have to be 4.3 x 10^18 % in order to select it over the ITM if the likelihood of the ITM model was 50%. Or the other way … if the Fed model had a likelihood of 99%, then the ITM would have to have a likelihood of 1.1 x 10^-15 % to lose to it.

Now I’m not sure all of those parameters are necessary to describe inflation and there are other things described by the Fed model like the capital stock, but as we say in … there’s a lot of margin.”

Note: I cut out a word where I put “…” so as not to bias you. Does this seem interesting to you at all? Do you think the author of this new theory and accompanying models should be encouraged?

A quick follow on to the above: the same theory I discussed above produced these results with the empirical data in the left hand plots spanning multiple countries and decades. The clusters of theoretical curves are intended to give a feel for the theoretical distribution across random economies. In the two sets of curves (top and bottom), there is “literally one parameter per country” according to the author.

Tom Brown: I meant to write “right-wing cred”. Cochrane advocated converting national debt into bank reserves, at Hoover. I think the idea is not PC in right-wing circles and so flopped. By this very PC-rant in the WSJ, Cochrane is re-establishing his credentials.
Sadly, macroeconomics is just politics in drag.

… if you examine that last set of plots, you might be able to tell that the theory offers an explanation for why the QTM holds in some countries, over some time periods, but not in others. For example, even though Sweden is experiencing below target inflation, the theory says its CB should have no trouble hitting a “market based” target such as an IT, NGDPLT, or price level target, while it predicts some other CBs should have trouble with this. A statistic can be calculated to distinguish one circumstance (QTM holds) from the other (QTM breaks down).

In addition, the theory is quantitative, but not ad-hoc (not based on regressions), and it does not require micro foundations and associated utility functions, agents, expectations, etc., but it does apply to micro too. And it is very much falsifiable.

David (and Tom) thanks for your kind comments. I should have written that the model is “not mathematizable to make precise predictions” because surely we can mathematize nearly everything but the issue is whether that is always realistic. I have found that there are two different problems with the mathematizing of any scientific model with more than two compartments, for the purposes of precise prediction in ANY field: N-compartments, and new emergence:

1. too many “forces” to solve simultaneously (analogous to the 3-body or N-body problem, which can only be solved by special cases of holding the third term neutral or in limbo — such as the DSGE’s do?) In domestic macro there are 6 connections between 4 compartments, and, as if that were not bad enough, in macro every one of these connections is doubled (at the least!), i.e. there are at least TWO two-way flows between each; and

2. each compartment may have newly emergent functions from inside, because they work according to different logics and also contain creative actors. In this case, A. in finance, the repo market took on mortgage derivatives to partly supplant Treasuries as overnight interbank collateral (and thus any sudden change in perceived value engendered systemic risk in that subsystem, freezing almost all activity and requiring a bailout) and on the other hand B. the housing market had been contributing substantially to DEMAND spending in the main real cycle of goods/jobs (to the tune of around $1 trillion a year).

How could ANYONE ever have maintained that demand is not the problem, there?

I am astonished and dismayed that 6 years after the crash, so many economists are still clutching at old inadequate models. It is hard not to see it as an analogy to medieval scholasticism. Why do they do it? Because they DO need math models — they have received this method from the other sciences where it is more applicable, and they have touted it as the method to pursue. It has gone so far as to get the psychology of the actors wrong: altruism is a big micro component in reality, for example, and that fact is denied mostly by corporate leaders and economics students who are taught that self-interest predominates. The true method for economics may be far more pluralistic and ad hoc.

“With the government able to borrow at negative real interest rates, the present value of funding such projects is almost certainly positive.” This seems unlikely. You are assuming at the very least positive operating cash flows, and surely there are plenty of possible infrastructure projects where that is not likely (e.g., Amtrak). That said, there are plenty of conservatives (probably including Cochrane) who would could support infrastructure programs with a positive NPV, measured honestly with realistic assumptions. Of course, with an administration that labels every conceivable income transfer program a form of “investment,” one might be a little wary of its NPV estimates.

But honestly and realism would force us to include the reduction of transaction/transformation costs of (say) Amtrak, which extends to a lot of money saved in automobile purchases, fuel purchases, highway road maintenance, etc, that would be required to perform the same transportation task of Amtrak by other means. Therefore the honest NPV must include much, much more than operating cash flows. Some of it is not even monetizable for calculation: personal time and physical effort that is saved, for example. Government like any institution can reduce transaction/transformation costs, and increase total welfare. It is curious (again) that conservatives who idolize Coase (correctly, IMHO) should ignore the direction of his central point!

While you make an interesting theoretical point, one problem is that once you introduce the concept of non-quantifiable welfare benefits, you open the door to purely political manipulation. I don’t object to calculating the NPV of a project that is alleged to produce a public good by looking at a broader range of costs and benefits than just GAAP operating cash flow, so long as they can be quantified by widely accepted methodologies, consistently applied, and use realistic assumptions (about discount rates, utilization rates, etc.) Otherwise, every project that some politician wants to spend scarce public dollars on is presto-chango a valuable, NPV project. Prof. Cass Sunstein’s approach at OMB illustrates the kind of political manipulation to which I object.

“Otherwise, every project that some politician wants to spend scarce public dollars on is presto-chango a valuable, NPV project.”

Not necessarily. There are two sorts of decision-making, by prices and votes. There are clearly non-quantifiable welfare goods, yet somehow we make decisions about them. What cannot be quantified can be decided by votes. Sticking to what is monetarily quantifiable doesn’t even solve the problem of political manipulation, it just introduces it through the back door. As we all know.

It is getting long past time for economists to realize that this too is the proper subject of economics, and that these things are what can make the provision of non-market, even non-quantifiable goods to be as efficient as anything performed by the market. As Coase said, economists don’t know half of economics.

I don’t disagree with what you are saying about the role of economists. I think we would be better off, however, if politicians said something along the following line: “This is a negative NPV project from a financial [and economic] point of view but I think we should build it any way because of the following non-quantifiable benefits: x, y, and z.” That would greatly clarify the public discussion versus the present state where politicians claim that every thing they can think of to spend money on constitutes an “investment.”

So your complaint is about the use of the word “investment”? I agree that our language has been over-economisticized (to invent a word), to the detriment of meaning and logic. But how else would you have a politician speak about education? Or speak about universal access to healthcare? Never mind the unquantifiable benefits to peace of mind and personal time saved, because even the quantifiable benefits are incalculable, due to the N-dimensions of future dynamic effects upon life and economy. To even worry about the dollar costs of healthcare in an era of plenty seems silly. What do you say to John Cochrane, who wrote that individuals must “feel the correct economic signals to shop for cost-efficient health insurance and health care”? I’m feeling I need an emergency appendectomy, but I must also have felt the “correct economic signals” to shop around: shouldn’t we declare that language obsolete, also?

Lee, regarding solving a 3-body problem, honestly, I’ve never tried (so I may be off the mark here), but I’d be surprised if a solution couldn’t be found numerically. However, I can certainly believe that a closed form solution cannot be written down, except for special cases.

There is no general closed form solution for quintic equations (5th or higher order polynomials set to 0) either, but we can get arbitrary precision solutions to them using numerical methods.

About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.